ECB searches for ways to boost sagging eurozone

By BY DAVID McHUGH, AP Business Writer
| 12:22 a.m.June 5, 2013

European Central Bank President Mario Draghi walks past the flags as he leaves from the venue of the International Monetary Conference in Shanghai, China, Monday, June 3, 2013. (AP Photo/Eugene Hoshiko)
— AP

European Central Bank President Mario Draghi walks past the flags as he leaves from the venue of the International Monetary Conference in Shanghai, China, Monday, June 3, 2013. (AP Photo/Eugene Hoshiko)
/ AP

FILE - In this May 2, 2013 file photo the new headquarters of the European Central Bank is under construction in Frankfurt, Germany. The European Central Bank says the continent's financial system remains fragile and exposed to risks, including a downturn in markets as well as trouble among banks as they face more bad loans in a weak economy. The ECB's latest financial stability review said Wednesday, May 29, 2013, that the weakening of the banking sector threatens to cause a flare-up in the 17c— AP

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FILE - In this May 2, 2013 file photo the new headquarters of the European Central Bank is under construction in Frankfurt, Germany. The European Central Bank says the continent's financial system remains fragile and exposed to risks, including a downturn in markets as well as trouble among banks as they face more bad loans in a weak economy. The ECB's latest financial stability review said Wednesday, May 29, 2013, that the weakening of the banking sector threatens to cause a flare-up in the 17c
/ AP

To stimulate growth, the ECB has already cut its benchmark interest rate to a record low, reducing borrowing costs for business and consumers in the 17 European Union countries that use the euro.

The ECB has also given banks more than 1 trillion euros ($1.3 trillion) in cheap, three-year loans to help mitigate the effects of Europe's financial crisis. And it offered to buy unlimited amounts of government bonds to boost investors' confidence that no countries would default on their debts. No bonds have been bought, but the mere offer has significantly lowered borrowing costs for heavily indebted countries such as Italy and Spain.

But these steps have not pulled Europe out of its economic funk. The eurozone economy has contracted for six straight quarters. The economy shrank by 1 percent in the first quarter over the same quarter a year ago. Unemployment is at 12.2 percent - the highest since the euro alliance was created in 1999.

Markets may get a clearer idea of further measures the ECB is considering after its monthly rate-setting meeting on Thursday. Last month, the 23-member governing council cut its benchmark refinancing rate a quarter-point to a record low of 0.5 percent. Most economists do not expect a rate cut Thursday, but many think the ECB will eventually cut rates or take other steps if the economy doesn't start growing.

Carsten Brzeski at ING said the bank might take a "timeout" but that the "environment still looks too fragile and uncertain for the ECB to take a back seat."

Speaking to reporters after last month's rate-setting meeting, ECB President Mario Draghi said the ECB stood "ready to act if needed" to give the eurozone a further boost.

Yet economists and even top bank officials say lower rates alone won't help much. The ECB's refinancing rate sets the cost of the loans it makes to banks and influences many borrowing rates across the economy. Problem is, the low ECB benchmark rate is not being passed on by the banks in the countries hardest hit by the debt crisis, such as Spain and Italy. Banks remain risk-averse in the aftermath of the financial crisis and new rules limit how much they can lend relative to how much capital they have. Some banks are having trouble borrowing themselves. So credit is hard to come by - and worst hit are small businesses.

The ECB is looking - hard - for a new way to boost a rough economy. To find one, it may have to pursue unorthodox and possibly risky methods.

Here is a look at what the ECB might try:

MORE CREDIT TO BANKS: When banks borrow from the ECB, they must put up collateral, usually bonds, in the event of a default. But the loans can be far smaller than the value of the bonds. This ensures the ECB will get its money back but means less credit for the banks. To give the banks greater financial firepower, the ECB could loosen its loan requirements so that banks can borrow more for every euro of collateral they put up.

GO NEGATIVE: Draghi has said the ECB has examined charging banks to maintain deposits at the bank by paying a negative interest rate. Banks park billions in cash at the ECB as a safe short-term home for money that isn't being invested or loaned. The bank already cut the deposit rate to zero from 0.25 percent in December. Draghi said after the ECB's May 2 policy meeting that a negative rate is not out of the question.

A negative rate could spur banks to lend that money instead of stashing it. Still, several top ECB officials and economists have been skeptical. For one thing, negative rates could dent bank profits just as they're rebuilding their finances. And banks could simply pass on the costs to customers in higher lending rates - the opposite of what the ECB wants.

SMALL BUSINESS RESCUE: To encourage banks to lend more to small businesses, the ECB is talking with other European officials about the possibility of having a government body guarantee these loans, much the way that Fannie Mae guarantees mortgage loans in the U.S.

Banks can bundle their small business loans into bonds just like they do with mortgages. These bonds are sold to investors, who collect the interest payments and take on the risk of defaults. Banks can use the proceeds from these sales to lend more to businesses.

One way to increase this activity would be for a government entity to guarantee the small-business loans. That would increase investor confidence in the bonds.

The ECB is encouraging a discussion of this idea, but it would not be the entity to back these loans. That could fall to the European Investment Bank, which is run by the European Union and already makes loans to small businesses.

Martin Hellmich, a professor of financial risk management at the Frankfurt School of Finance & Management, said having a European authority backing the bonds was crucial to this method's success.

"The guarantee is a very important factor here," he said.

LOOK AHEAD: One way the ECB can encourage investors, businesses and consumers to spend and invest more is to give a clearer indication of what it is planning for the long term. For example, the ECB could say that it plans to keep rates low for a specified time - just as the U.S. Federal Reserve has done. All the ECB has said so far is that rates will stay down "for as long as needed."

In theory, the ECB could also join the Fed, Bank of England, and Bank of Japan in large-scale purchases of government bonds. By buying up bonds from the banks, the amount of money in circulation would increase and help drive down long-term interest rates and spur borrowing, spending and investing. Such an across-the-board program, known as quantitative easing, would be different from the current bond purchase program the ECB is offering, which is aimed at individual countries that agree to take steps to cut debt, and hasn't been activated.

But analysts say it's unlikely the ECB will do quantitative easing, for technical, legal and political reasons.

Draghi has said it would be difficult to find one long-term rate to target, since euro countries' bond markets are all different.

The move would also face strong opposition in Germany, where the head of the central bank has warned such purchases get the central bank involved in bailing out government finances - something that it's forbidden to do. Creating new money can also drive up inflation, a concern that is especially strong in Germany and a potential conflict with the ECB's charter, which charges it to contain inflation.

Additionally, Draghi had enough trouble last year winning approval for the bond-purchase offer. Trying to launch another bond program could upset that hard-won consensus.